Can You Use a 529 Plan for Daycare Expenses?

A 529 plan is a savings vehicle designed to help families prepare for future educational expenses, offering tax advantages that make it an appealing choice. Many parents, however, question whether these funds can be used for daycare costs.

Standard Criteria for Educational Expenses

The Internal Revenue Code (IRC) defines qualified educational expenses under a 529 plan, focusing primarily on post-secondary education. These expenses include tuition, fees, books, supplies, and equipment required for enrollment at eligible institutions. The Tax Cuts and Jobs Act of 2017 expanded 529 plan use to cover up to $10,000 annually for K-12 tuition. Eligible institutions must be recognized by the U.S. Department of Education and participate in federal student aid programs. This includes most colleges, universities, vocational schools, and some foreign institutions. Room and board are also covered if the student is enrolled at least half-time, subject to specific cost limitations.

Treatment of Daycare Costs

Daycare costs are not considered qualified educational expenses under a 529 plan. The IRS does not classify daycare as a formal educational setting, excluding it from eligible uses. Using 529 funds for daycare triggers federal income tax on the earnings portion of the withdrawal and a 10% penalty. Families seeking tax-efficient ways to manage daycare expenses might explore the Child and Dependent Care Credit, which offers a percentage of daycare costs as a direct tax reduction.

Tax Implications for Nonqualified Use

Nonqualified withdrawals from a 529 plan result in taxes on the earnings portion at the account holder’s ordinary income tax rate, along with a 10% penalty. Additionally, some states may require the recapture of state tax benefits previously claimed, increasing the financial burden. Account holders should maintain detailed records of contributions and withdrawals to ensure compliance. Exceptions to the penalty, such as scholarships or attendance at a U.S. military academy, can help mitigate tax liabilities.

State-Specific Variations

529 plans differ across states, with variations in tax incentives, contribution limits, and eligible expenses. Some states offer tax deductions or credits for contributions to their plans, enhancing savings potential. States like New York and California provide diverse investment options, including age-based portfolios that adjust asset allocation as the beneficiary approaches college, supporting risk management and aligning with funding timelines.